Finance: economic toxin or lifeblood?

When and why does finance stop being the lifeblood and turn into a toxin for economic activity? That was the question posed by top Italian economist, Professor Marco Pagano, at the annual Henry Thornton Lecture at Cass Business School.

Professor Pagano, from the University of Naples Federico II, argued the change occurs when finance becomes too large relative to the underlying economy. "It then stops contributing to economic growth and starts threatening the solvency of banks and systemic stability," he said.

He blamed the "hypertrophy" of finance on an unregulated shadow banking sector, lax monetary policy and the expectation that, faced with widespread financial meltdown, banks would be bailed out.

Professor Pagano also attacked regulators for failing to prevent financial hypertrophy, saying they were slow to react to financial innovation and regulatory flaws. "A leading example is deposit insurance which was introduced to prevent bank runs, but ended up contributing to excess risk taking by bank managers," he said.

But ultimately, he argued politicians are the "root cause" of financial hypertrophy. The euphoria associated with a credit bubble creates a vast political support around it, he said, while the few who raise objections against its sustainability are seen as "party-spoilers".

According to Professor Pagano: "Once started, there is no constituency to stop them, because everyone simply tries to grab as large gain as possible until the bubble lasts. Sadly this suggests that the "dark side" of finance is hard to separate from a "dark side" of politics and society."

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